Creating the right climate for growth

July 24, 2018

South Africa continues to face significant socio-economic challenges, many of which have worsened in recent years. Some of these challenges are reflected in persistent high income and wealth inequality, others are reflected in service delivery protests and demands for free tertiary education or the steady rise in the number of social grant recipients, which is rapidly approaching 18 million people.

The country has also experienced a substantial increase in the level of corruption over the past ten years. In 2007 South Africa was ranked 43rd in the world corruption index, but plunged to a global ranking of 71st in 2017.

World corruption perception index: South African world ranking

Source: STANLIB, Bloomberg

Unfortunately, these socio-economic challenges have been aggravated by the deterioration in government’s fiscal balances over the past eight years, including the rapid rise in government debt, systematic increase in government consumption spending at the expense of infrastructural development and international credit ratings, the destruction of State Owned Enterprises’ (SOEs) balance sheets, and the slowdown in tax revenue collection.

SA government (including contingent debt), % of GDP

Source: STANLIB, Bloomberg

All of this highlights the urgent need for South Africa to find a way to lift economic growth meaningfully, but in a manner that leads to sustained job creation. Without widespread and sustained job creation the authorities will find it increasingly difficult to address the frustrations of the population, raising the risk of increased social and political protest that would further undermine consumer and business confidence.

Pessimism and optimism

Given these circumstances, it is understandable that the first quarter 2018 decline in South Africa GDP performance of -2.2%, coupled with the release of persistently high unemployment data, is extremely disappointing. While most economists had forecast a fall-off in economic activity in the first three months of the year, they had not expected the economy to contract as much as it did, or to show a meaningful slowdown in activity in most sectors of the economy. The latest GDP data does not suggest that South Africa is necessarily going back into recession, but the extent of the decline does justify a downward revision to South Africa’s GDP growth forecast for 2018 to 1.5% from an initial consensus estimate of 2.0%.

Emerging market portfolio flows: 2017 vs 2018

Source: STANLIB, Bloomberg

There was clearly reason for renewed optimism at the start of 2018, following the political changes that unfolded in December 2017. In particular, Cyril Ramaphosa’s State of The Nation address in February 2018 outlined a more optimistic outlook for the economy. This was followed by a reasonably disciplined National Budget as well as a material change in government’s approach to managing key SOEs such as Eskom, Denel, PRASA, and SAA. The government also embarked on a process to reform the South African Revenue Service and was able to change the leadership structure of the ailing North West Province as well as other key areas within the public sector. This, together with other positive developments, such as the decision by Moody’s in March 2018 to keep South Africa’s credit rating on “investment grade” and President Ramaphosa’s “new dawn” and pledge to turn the tide of corruption, were all encouraging. However, even under ideal circumstances it would take a considerable length of time for these developments to boost economic growth and household income levels on a sustainable basis.

Unfortunately, a number of key policy issues continue to weigh negatively on investor and business sentiment. These include key aspects of the proposed mining charter, the possibility of land redistribution without compensation and the impact of government’s initiative to introduce a new system of National Health Insurance and how it will be funded. There is a risk that economic policy will become much more populist as the country moves closer to the National Election around the middle of 2019.

Weighing up policy choices

Economic policy is always a choice between competing alternatives. Leadership makes the best policy choices in the long term when it pays equal attention to the unintended consequences of any policy initiative.

The damage inflicted on the South African economy over the past ten years, especially the deterioration in public sector finances, means the authorities have far fewer policy choices available today to stimulate economic activity than would normally be expected. For example, it would not be practically feasible for government to stimulate economic activity through a sharp cut in tax rates. Tax revenue has under-performed budget in four out of the last five years, and the authorities have been forced to hike taxes in order to raise additional revenue. Equally, a sharp cut in interest rates is unlikely to unlock private sector fixed investment activity, given the ongoing policy uncertainty in key areas of the economy that has undermined business confidence. In other words, the cost of capital is not the key factor limiting private sector expansion, but rather policy ambiguity.

More recently, it has become apparent that successfully stimulating South African manufactured exports has also become a less viable policy option given the current increase in global trade protection and concerns about an escalating “global trade war”.

South Africa vs emerging market manufacturing

Source: STANLIB, Bloomberg

Fortunately, one key policy option remains viable – unlocking business expansion through a concerted effort to boost business confidence. In recent years, the South African economy has been struggling with a fundamental lack of private sector capital expenditure, including maintenance capex. In fact, private sector fixed investment has declined by more than 6% since the end of 2014, and remained exceptionally weak in the first quarter of 2018. Successfully stimulating private sector investment, even if initially this implies only a pick-up in maintenance capex, could start to unlock a self-sustaining growth dynamic that would lift employment, household incomes and tax revenue.

South Africa business confidence (BER)

Source: STANLIB, Bloomberg

While South African non-financial corporate deposits within the banking sector recorded a near record high of R788 billion in April 2018, up from around R470 billion in 2009, shortly after the financial crisis, this is not necessarily a good indication of the overall financial strength of the domestic business sector or its ability and willingness to undertake additional fixed investment spending. Instead, it is more useful to look at a wider range of financial indicators, including the level of indebtedness.

South Africa corporate deposits

Source: STANLIB, Bloomberg

Is there money to spend?

According to the IMF’s World Debt Database, South Africa’s non-financial corporate debt amounted to a relatively modest 39.1% of GDP at the end of 2017. This suggests that South Africa’s business sector is one of the least indebted when compared with other emerging economies. Furthermore, the foreign currency component of South African corporate debt amounted to only 16.5% of GDP. Once-again, while not inconsequential, this is relatively modest compared with many other emerging markets. All of this would suggest that the South African business sector, especially large and to some extent medium-sized companies, has the financial strength to undertake additional investment spending, but lacks the confidence needed to justify the increased risk.

Emerging market corporate debt as % of GDP

Source: STANLIB, Bloomberg

In this regard, it is interesting to see that the domestic component of South Africa’s corporate debt is lower today as a percentage of GDP than it was ten years ago, while the foreign debt component has moved somewhat higher in recent years. Presumably this has occurred as a consequence of South African business undertaking some expansion initiatives outside the country.

Overall, South Africa’s labour market has failed to gain any meaningful traction over the past few years with the unemployment rate, especially for the youth, remaining exceedingly high by global standards. The high rate of unemployment contributes much of the social tension and anguish experienced in South Africa on a daily basis, especially among the youth.Increasing employment in South Africa has to be the number one economic, political, and social objective, and can only be resolved meaningfully through a concerted and sustained effort to improve skills development as well as encourage private sector fixed investment spending, business development and entrepreneurship.

SA number of people unemployment (std def)

Source: STANLIB, Bloomberg

While short-term political considerations, especially in the run-up to the 2019 National Election, might distract from the country’s ability to encourage private sector investment, ultimately the growth prospects for the South African economy are, now more than ever, linked to the country’s employment prospects. Employment prospects are directly related to business confidence and investment, which are ultimately a function of politics and economic policy.